IEEJ:Published in September 2015 All rights reserved

Research Paper

Recommendations
fora better functioning LNG market in Asia

September 2015

The Economic Research Institute for ASEAN and East Asia
The Institute of Energy Economics, JapanIEEJ:Published in September 2015 All rights reserved

Acknowledgement
The Economic Research Institute for ASEAN and East Asia (ERIA) and the Institute ofEnergy Economics, Japan (IEEJ) gratefully acknowledge the contribution of Siri
Jirapongphan, Madhura Joshi, Neil Lambie, Ho-Mu Lee, Tatiana Mitrova, Jane Nakano, Jin
Ho Park, Xunpeng Shi, Jonathan Stern, Xiansheng Sun, Laszlo Varro, and Duan Zhaofang,
and anonymous reviewers from Australia, European Union, and Qatar for providing usefulcomments and suggestions for analysis and thereof developing recommendations.

The ERIA and the IEEJ takes full responsibility for the wording and content of this report.

Introduction
As a result of the 1st series of Multilateral Joint Study Group on LNG in 2014, Masakazu
Toyoda, CEO and Chairman of IEEJ presented “Recommendations to Realize the Sound
Development of LNG Market” at the 3rd LNG Producer-Consumer Conference in November
2014.

LNG market is undergoing dramatic changes especially since the latter half of 2014. The
most significant one is the collapse of oil prices, which led to lower Asian LNG prices. New
liquefaction capacities and slower-than-expected demand decreased spot LNG prices evenlower. As a consequence, “Asian Premium” of LNG shrunk substantially.

While lower price is welcome for LNG importers in Asia, there remain unresolved issues
such as the lack of Asian benchmark price for LNG, inflexibility of LNG contracts andsecurity of gas supply. On the other hand, lower oil and gas prices pose a question as tohow upstream investment is secured to ensure future LNG supplies, taking into
consideration the long lead time for gas development. In the summer of 2015, 2nd series ofMultilateral Joint Study Group on LNG have examined these issues. This document has
been drafted by IEEJ with an aim to make new recommendations to stakeholders andgovernments to promote sound development of the LNG market in Asia, based on
discussions with a group of experts, and to be presented at the 4th LNG Producer-Consumer
Conference on 16 September 2015 in Tokyo.

1IEEJ:Published in September 2015 All rights reserved

Recommendations fora better functioning LNG Market in Asia
(Draft, as of August 2015)

Background: Changes and challenges in Asia LNG market
LNG prices in Asia had been considerably higher than those in Atlantic market especiallybetween 2011 and 2014. The price gap, or Asian Premium of LNG, could not be explainedby transportation cost between Atlantic and Asian markets. The huge premium was aserious problem for LNG importing countries in Asia.

Relaxation of supply-demand balance and the collapse of oil prices led to lower LNG priceand decreased Asian Premium of LNG. However, there remain four unresolved challenges
such as below.

1. Calling for flexibility in LNG trade in Asia
LNG transactions in Asia are usually characterized by large volume, long-term, and rigid
contractual terms. These characteristics have been brought about by high gas transport,liquefaction and storage cost of natural gas, as well as high investment risk associated with
upstream developments and illiquid LNG market in Asia. Therefore, traditional LNG
contracts for Asia feature certain terms to reduce upstream investment risks and secure
operation in a quasi vertically integrated manner.

First, products typically have been sold under long-term contracts that often span more than
20 years. This is still largely the same today especially for new LNG projects, while someexisting LNG projects offer shorter contracts.

Secondly, term LNG contracts include so called “take-or-pay” clause where a buyer isrequired to pay for the cargoes even if it cannot take them for whatever reasons, although
5-10% upward and/or downward quantity allowance is typically embedded in the contract.

Thirdly, in most LNG contracts for Asia, products are only shipped to specific geographicalpoint(s) or country under “destination clause”. This clause was originally intended to lower
investment risk by reinforcing security of supply for buyers and of demand for sellers. With
destination clause, even in the case of FOB contract, a buyer is not allowed to resell a cargo
to another buyer without seller’s consent. In Europe, the destination clause was made2

IEEJ:Published in September 2015 All rights reserved

illegalized to be incompatible with Rome Treaty by European Commission and almost all
destination clauses were removed in FOB contracts.

While some contracts offer relatively flexible terms in recent years, inflexibility still remains inmany LNG contracts in Asia, importers need flexibility in gas trade not only to accommodate
demand fluctuation but also, in the case of Japan, to prepare for unpredictable future
domestic gas demand as a result of power and gas market liberalizations. Flexibility is also
important for establishing gas on gas (market) pricing because it is only possible throughflexible trading activities and subsequent liquidity growth of LNG market.

2. Seeking for appropriate price formation
It is well known that LNG in Asia has traditionally been priced in relation to crude oil price –typically Japan’s average crude import price or JCC. Such oil indexation is not only an issue
for price formation but also for flexibility because, due to the structure of price formulae, oilindexation prices cannot follow market fundamentals in a timely manner.
The oil indexation originated from Europe where the majority of imported gas was priced byformula so that natural gas can compete with alternative fuel (mainly fuel oil and gas oil) in
the market of importing countries. However, gas-on-gas pricing has been increasing inEurope because wholesale markets (hubs) became liquid enough to replace oil-indexed
prices that could not follow the fundamentals of LNG market especially in 2009 and 2010.

In a high oil price era, some importers and observers in traditional Asian LNG importing
countries started to question the relevance of oil-indexation as price formation process
because natural gas has already replaced oil to a significant extent and thus little
competition between natural gas and oil especially for power generation. As far as Chinaand India are concerned, dominant fuels are coal for power generation and industry sectors,and biomass and electricity for household and commercial sectors. Therefore, in thosecountries, competition between oil and natural gas is limited in the first place. In other words,
one can question whether oil indexation as natural gas pricing for Asian importers is still
appropriate.

Many Asian LNG buyers are seeking alternative pricing in recent years. US LNG prices willbe based on Henry Hub price, liquefaction and transportation costs. Some of the newcontracts feature hybrid pricing of Henry Hub or NBP or spot LNG price and oil indexation.
With pricing diversification continuing, it is clear that LNG price for Asia should reflect market
fundamentals in Asia with accuracy and timeliness.

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3. Ensuring gas security
Gas security issue has been spotlighted in Europe especially since mid 2000s. Gas supply
disruptions, in particular in a winter heating season, undermined security of supply in some
European countries. In response to this situation, the EU intensified its gas supply security
discussions and implemented some policies which include diversifying supply sources andenhancing flexibility of gas supply on a global basis.

The discussion has become widely recognized and shared among many countries evenoutside of Europe, as demonstrated by a declaration of the Brussels G7 summit in 2014 that
support the relaxation of destination clauses for promoting gas security. It is based on acommon perception that flexible, transparent, and competitive energy market including
gas/LNG is one of core principles to build energy security. In addition, EuropeanCommission has developed new concept of ‘Energy Union’ which includes gas/LNG supplysecurity as one of its pillars.

The series of discussions has enhanced awareness of LNG consumers in Asia for an
importance of LNG supply security and trade flexibility. While each importing country in Asia
faces different energy challenges, rising import dependency is urging importing countries topursue flexible LNG supplies to ensure gas security.

4. Securing investments to ensure future LNG supply
Asian LNG demand is expected to double and reach 363 million tonnes per annum in 2040,
according to IEEJ. As such, continuous investment which will commercialize supply
potentials especially in Australia, North America, Russia, and Africa is expected to ensure
security of LNG supply in the future in Asia. However, it is becoming critical to secureadequate and timely investments under the low gas price circumstance..

Long-term contracts have played and still play a major role to commercialize new LNG
projects. Flexible market does not necessarily exclude long-term contracts. On the contrary,
it is important to recognize the utility of long term contracts especially for new, remote, green
field, large scale projects. However, future long-term contracts should feature gas on gas(market) pricing.

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IEEJ:Published in September 2015 All rights reserved

Recommendations
LNG market is in transition in terms of geographical and quantitative expansion,
diversification of price formations, and lower oil and gas prices. In order to balance benefits
between importers and exporters and to find workable solutions for sustainable LNG market
development in varied energy situation in each importing and exporting countries, LNG
market players and policy makers are encouraged to enhance their efforts to create more
flexible, transparent, and sustainable LNG market in Asia. While the private sector is mainly
responsible for commercial deals, the public sector is encouraged to support to improvebusiness environment for developing a better functioning LNG market especially in terms offlexibility, price formation, gas supply security, and securing necessary investments.

1Flexibility
Enhancing flexibility is the key to a better functioning LNG market in Asia. Not onlyinternational LNG but domestic gas markets should be more flexible.

1.1

Contractual flexibility should be enhanced by eliminating destination restrictionsin FOB contracts and relax them in DES contracts.

1.2

Policy makers are recommended to enhance domestic gas market liquidity
through liberalizing domestic gas market and prices, and developing adequate
and accessible gas infrastructure capacities by promoting such measures as thirdparty access to gas infrastructures where applicable.

2Price formation
Oil indexation rapidly lost its relevance in recent years because oil is increasingly lesscompeting against gas and it is not able to track LNG market fundamentals. Gas on gas
competition (market) pricing is fundamentally desirable so that the market fundamentals
of LNG can be directly reflected on price.

2.1

Price formation at Asian gas/LNG hub(s) such as wholesale domestic gas market
in Asian importing countries as well as in spot LNG market should be pursued.
Singapore intends to establish a hub and some other countries are exploring thepossibility of this kind including Japan. Further investigations and actions toward
establishing Asian gas/LNG hub(s) are suggested.

2.2

It will be useful to diversify price formation of LNG in Asia by linking with North
American and European hub pricings and spot LNG pricing while tackling with the5

IEEJ:Published in September 2015 All rights reserved

followings: (a) modifying JCC pricing to better reflect market conditions; (b)making continued efforts to develop Asian gas/LNG hub(s).

3Gas supply security and role of functioning marketGas supply security attracts greater interest not only in Europe, where the conflict in
Ukraine overshadows, but in many Asian countries as their gas demand and importdependency soar.

3.1

Gas supply security should be improved by both supply and demand side
measures, such as diversification of supply sources including pipeline gas,developing emergency response scheme, improving energy efficiency, removing
price subsidies, and enhancing demand flexibility.

3.2

Contemporary approach such as flexible trade, for instance between Europeanand Asian market, and appropriate price signal of LNG are suggested to bepursued as they are important elements that can ensure, particularly short-term,
gas supply security in a global LNG market. Traditionally, long term contract has
played this role. However when considering a dramatically changing
circumstances in each regional market, where steady progress takes place
toward market liberalization, it is obvious that long term contact alone cannot fulfil
the requirement of supply security.

3.3

In this light also, destination restrictions in contract need to be eliminated orrelaxed to enhance flexible trade of LNG.

4

Securing necessary investments
It is critical to secure adequate and timely investments to realize additional LNG supply
potential to meet with growing LNG demand in Asia, particularly in a current lower gas
price circumstances.

4.1

The governments of LNG exporters are expected to maintain transparent andconsistent policy to encourage upstream developments, while respecting socialand environmental consideration and restrictions. The governments of LNG
importers are expected to promote adequate and accessible infrastructuredevelopments.

4.2

Take or Pay has played and still play an important role to commercialize new
LNG project. However, in response to substantially changing market, it issuggested to pursue expanding allowances of DQT (Downward Quantity6

IEEJ:Published in September 2015 All rights reserved

Tolerance) and UQT (Upward Quantity Tolerance) as much as possible.
4.3

Equity participation of importers and public support are suggested to be hired
when private finance is not sufficiently available due to price uncertainty in thefuture.

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IEEJ:Published in September 2015 All rights reserved

List of the Study Group Members
Siri Jirapongphan

Petroleum Institute of Thailand, Thailand

Madhura Joshi

The Energy and Resource Institute, India

Ken Koyama

The Institute of Energy Economics, Japan

Ichiro Kutani

The Institute of Energy Economics, Japan

Neil Lambie

Resources and Energy Economics Branch, Australia

Ho Mu Lee

Korea Energy Economics Institute, Korea

Yanfei Li

The Economic Research Institute for ASEAN and East Asia

Tatiana Mitrova

Energy Research Institute, Russia

Tetsuo Morikawa

The Institute of Energy Economics, Japan

Jane Nakano

Center for Strategic and International Studies, USA

Jin Ho Park

Korea Energy Economics Institute, Korea

Xunpeng Shi

Energy Studies Institute, SingaporeJonathan Stern

Oxford Institute for Energy Studies, United Kingdom

Xiansheng Sun

CNPC Economics & Technology Research Institute, China

Masakazu Toyoda

The Institute of Energy Economics, Japan

Laszlo Varro

International Energy Agency

Duan Zhaofang

CNPC Economics & Technology Research Institute, China

8Please direct inquiries to: report@tky.ieej.or.jp